How Implied Volatility Works in Trading Options

The implied volatility of an option is not constant. It moves higher and lower for a variety of reasons. Most of the time the changes are gradual. However, there are a few situations in which options change ​price in quantum leaps—catching rookie traders by surprise.

When the market declines rapidly, implied volatility (IV) tends to increase rapidly. If there is a Black Swan, or similar event (market plunge), IV is likely to explode higher.

When the market gaps higher, especially after it had been moving lower, all fear of a bear market disappears and option premium undergoes a significant and immediate decline.

Once ​the news is released (i.e. earnings are announced or the FDA issues a report), IV is often crushed.

When news is pending for a given stock (earnings announcement, FDA results on a drug trial, etc.) option buyers are more aggressive than sellers, and that buying demand results in higher implied volatility and therefore, higher option premium.

Let's look at one example to see how that works and why it is so important for every trader to pay attention to option prices. You cannot afford to make a trade while ignoring the cost. Learning that lesson is often a very expensive proposition.

Do not assume that the current market price of any option or spread represents a fair value for your trade plan.

The market price represents the current consensus of fair value by those participating in the trade. And for their purposes, it may be a fair price. However, the price may be way out of line based on your rationale for entering into the trade.

1. XZW is $49 per share and earnings will be announced after the market closes (in 10 minutes) today. Most traders, investors, and speculators have already made their plays. But the options are still trading actively.

2. Let's consider options that expire in 30 days. The "customary" implied volatility for these options is 30 to 33, but right now buying demand is high and the IV is pumped (55).

If you want to buy those options (strike price 50), the market is $2.55 to $2.75 (fair value is $2.64, based on that 55 volatility).

If you are bullish enough to consider owning the $55 calls, the market is $1.05 to $1.15 (fair value is $1.11).

3. The news is good. The next morning, XZW opens for trading (after a short delay due to an order imbalance) at $53. That's an 8% upside gap and should represent a nice result for bullish investors.

Not surprisingly, there are no longer many option buyers. In fact, the majority of those who bought options yesterday want to take their profits today. Because of so many sellers, the market makers establish their bid/ask spreads based on a volatility estimate of 30.

Why is the revised volatility estimate so low? Because there are no more news events pending before the options expire. In other words, there is no reason to expect that the stock will be any more volatile than usual. In fact, once the stock price finds its new, post-earnings level, it may be far less volatile than that. Yesterday there was a known event that could move the stock price. Today that is no longer true. Thus, options have lost much of their appeal.

With the stock at $53 and with IV at 30 (29 days to expiration), the option markets are:

Apr 50 call: $3.50 to $3.70 (fair value is $3.64)

Apr 55 call: $0.90 to $1.10 (fair value is $1.00)

In this example, the person who bought an option that was slightly out of the money (Apr 50 call) earned a decent profit ($1). But it required a $4 increase in the stock price to get that profit. If I were that option owner, I'd be very disappointed. Buying options when IV is 55 and selling when it is 30 is a sure way to lose money. If IV had declined only to 50, the call would be worth an additional $1. But the implied volatility was crushed to 30, and that 'extra' dollar' was never available.

The person who bought the Apr 55 call was even more disappointed because his trade lost money. If IV were 50, the call would be worth $2.14, or more than double its current value.

One Final Note About Implied Volatility

This is not a game for beginners. It requires experience to buy options when the news is pending. You must feel confident in your ability to estimate how the option prices are going to react to the news.

It is not enough to correctly predict the stock price direction when trading options. You must understand how much the option price is likely to change. Only then can you decide if it is worthwhile to make the play. Most of the time, these options are too expensive to buy.

The result: sell the spread for $2.50 or more (probably 10 cents more*).

Profit: between $0.80 and $1.00.* That is a return on investment of at least 47%. Note: the buyer of the Apr 50 call earned approximately the same dollar amount, but that is a return of only 33% ($0.90 on a $2.70 investment) because the cash required to make the trade was higher.

*When looking at bid and ask prices, it is impossible to know whether your limit order will be filled at a better price than your order seeks. My best guess is that we can get that extra "10 cents" mentioned above, but only when you enter a limit order. Remember that this is only an estimate.

The big takeaway is that it is wise to limit profit potential by owning spreads rather than single options—especially when a large volatility decline is likely to occur.